When something can’t be found at our house, I’m usually accused of throwing it in the trash. I admit I don’t like clutter, but just because this is true doesn’t mean I throw everything away. Kennametal (KMT) is proof of this. Kennametal manufactures precision-engineered metalworking tools and components, surface technologies and earth cutting tools. Kennametal has been on my possible buy list for years if not over a decade. I’ve followed them for as long as I can remember, but I’ve never owned them. Given their highly cyclical business and tendency to take on debt, I don’t expect to own them in the near future. For me, they are the definition of investment clutter.
Why do I keep investment clutter on my possible buy list? There are times I follow companies with debt if it’s a business I like and would consider purchasing assuming debt is reduced. Kennametal fits this description. Deleveraging sometimes occurs when new management comes in with a different financial mindset and capital allocation plan. Other times existing management becomes so financially distressed, they scare themselves into paying down debt and swear off excessive leverage in the future. I also like following Kennametal because they sell to several important industries and provide good detail on their end markets (transportation, energy, aerospace, general engineering, and earthworks).
I often hear or read about how balance sheets have improved since the financial crisis. Maybe for a few mega caps this is true, but for the average company this isn’t what I’m observing. In fact, I think balance sheets are worse. The often cited McKinsey study supports what I’ve noticed from my bottom-up analysis. According to McKinsey global debt has increased $57 trillion since 2007 through Q2 2014. Corporate debt has grown from $37 trillion to $58 trillion.
Given slower than normal sales growth this cycle, many companies have resorted to financial engineering to enhance sales and earnings growth. Debt is often used to acquire, buy back stock, and pay dividends. Kennametal has done all three this cycle and yes, their debt has increased.
I’m not in favor of highly cyclical companies taking on debt. Cyclical companies are called cyclical for a reason – they have volatile operating results with exhilarating booms and terrifying busts. For example, Kennametal generated EPS of $3.83/share in 2012 and lost -$4.71/share in 2015 (large charges). Guidance for fiscal 2017 is $1 to $1.40. Pick a number, any number! In my opinion, volatile earnings and cash flows do not mix well with high debt levels and their associated fixed cash costs.
While I’d prefer to own a high quality stable business at a discount, there’s nothing wrong with investing in cyclical businesses. I’ve owned several high quality cyclicals in the past and follow many. In fact, their volatile operating results often create stock price volatility, which can lead to opportunity. However, when investing in cyclical businesses, I have some golden rules. First, never extrapolate the booms or the busts – normalizing cash flows for valuation purposes is essential.
Second, during booms you must sell – do not buy and hold a cyclical stock. Sounds easy, but booms can be so intoxicating that making a sound investment decision becomes increasingly difficult as the stock and your adrenaline soar (investing under the influence, so to speak). I’ve found highly cyclical businesses are usually very overvalued or undervalued, but rarely priced just right. Take advantage of the volatility and don’t get greedy. And if you miss the boom or sell early, do not fear, cyclicals are the home of second chances.
Third, I only buy cyclicals with strong balance sheets. Buying a cyclical at a discount is irrelevant if the business can’t survive the cycle. As I’ve said hundreds of times in presentations to clients, I never combine operating risk and financial risk — I’ll take one or the other, but never both. Absolute return investors cannot have investments go to $0. Doing so is a serious investment crime for an absolute return investor. Thankfully my record is clean!
Why do so many cyclical companies take on debt? Most cyclical businesses are in mature industries. Markets like energy, auto, mining, and aerospace typically grow in-line with nominal GDP over an economic cycle. Under pressure to generate growth, mature cyclical companies often turn to acquisitions to expand market share. This is usually where most cyclicals get into trouble. We saw this most recently in the energy industry. Exploration and production (E&Ps) companies acquired land and invested heavily in energy service capital expenditures. The industry’s debt levels exploded higher with several E&Ps now in bankruptcy.
Similar to what happened in the energy industry, acquisitions and heavy investments are often done during the peak of the cycle when cash flows and credit are most abundant. As excessive capital and credit chases limited deals, many companies are eager to and are encouraged to spend well beyond their means, driving up financial risk along with acquisition prices.
Kennametal is a good example. During their last earnings boom, they made a large acquisition and took on debt. In November 2013, Kennametal acquired TMB (producer of tungsten metallurgical powders, tooling technologies, and components) for $607 million. The TMB acquisition expanded Kennametal’s “presence in aerospace and energy end markets.” Goldman Sachs was the advisor. In 2012, TMB had $340 million in revenue, $37 million in operating income and $45 million in EBTIDA. So Kennametal paid 2x sales, 16x operating income and 13.5x EBITDA. These are very expensive valuation multiples for a cyclical business. Kennametal also paid well over book value as they took on a large amount of goodwill for the deal ($244 million).
Shortly after the acquisition, Kennametal announced it would take restructuring actions and expected charges of $40-$50 million resulting from the acquisition and higher than expected TMB inventories. Charges at Kennametal continued as the boom it was enjoying in 2012 turned into a bust (several of its end markets are now in recession). Kennametal took a pre-tax impairment charge to goodwill of $153 million in March 2015 and another impairment of goodwill in December 2015 of $375 million.
Another reason cyclicals take on debt is they generate considerable income and free cash flow during their booms. This sounds counterintuitive. Shouldn’t high profitability and strong cash flows reduce debt? It should, but excess cash flow is often considered excess capital that many shareholders believe should be returned to owners. Company board of directors are under considerable pressure to do something when cash builds. Excess capital built during a boom also gives boards and management confidence – often too much confidence – to invest, acquire, or return capital. Similar to investing, large capital allocation mistakes are often made at the top of a business cycle, not at that bottom.
I like the idea of returning excess capital to shareholders, but when highly cyclical companies distribute cash, they often return too much and can quickly go from capital surplus to capital deficit. Once boom turns to bust, some cyclical companies that were making acquisitions or returning capital to shareholders are suddenly forced to raise high cost capital in order to survive (recent equity issuance by energy companies after stocks declined sharply is a good example). Insufficient capital and liquidity during busts can also cause businesses to be managed too defensively and can frighten away customers due to service or counterparty risk concerns.
In my opinion, too many activists, buy-side analysts, and sell-side analysts encourage and contribute to short-term thinking and poorly timed capital allocation decisions. I call them the Wall Street locusts. The Wall Street locusts are always on the lookout for a healthy balance sheet to devour and destroy before moving on to the next green pasture. I find this to be an interesting comparison to the pressures of holding cash in a portfolio when prices are high. Some investors want the portfolio manager to buy something with the cash, even though it may mean overpaying and result in future losses. Activists and analysts apply the same pressures to managements of cyclical companies. Acquire, buyback stock, or pay a dividend, but don’t just sit there with a strong balance sheet.
I disagree with the Wall Street locusts. In my opinion during booms, when free cash flow is high and capital is being accumulated, a highly cyclical company would be better served by retaining capital and liquidity. I believe capital would be better utilized during the bust to maintain adequate investment and spending. Furthermore, a strong balance sheet enables cyclical companies to not only survive, but thrive during recessions. A company with available capital is better able to acquire attractively priced competitors that may be distressed from overextending themselves during the boom. Assuming sufficient capital and liquidity, I also believe buybacks are reasonable uses of capital at troughs of cycles (when prices are most attractive). Imagine being an energy company currently with a debt free balance sheet and a large cash balance. Unfortunately, most of the energy industry is frozen and distressed because they leveraged up during the boom instead of preparing for the opportunity of the bust.
In my opinion, some activists, buy-side analysts, and sell-side analysts are not looking out for the best interest of public companies as their intentions are often short-sighted. In effect, they want a quick return on their investment and don’t plan to be around during the next bust. The activists usually want major change to the business structure that investors will view favorably, resulting in a higher stock price. Structural changes are often accompanied by major changes to the balance sheet. The buy-side is typically less aggressive than activists, but still encourage buybacks and dividends, even near cyclical peaks (after they’ve become shareholders). The sell-side likes acquisitions as they often come with debt and investment banking fees.
Instead of caving into pressure from Wall Street, I believe cyclical companies should think long-term (over an industry cycle) and fight demands from short-term investors whose recommendations are self-serving and are harmful to the balance sheet. A weak balance sheet not only increases the risk of bankruptcy during the next recession, it also reduces operational flexibility, detracts from investment, and may place the firm at a competitive disadvantage. In effect, companies that need liquidity to survive and prosper though an industry cycle need to prepare their balance sheets during the boom so they won’t be at an operational and financial disadvantage during the bust.
In fiscal 2013 and 2014 Kennametal bought back $135 million in stock. During that period its stock traded near $40 on average, significantly above today’s price of $27 and its recent low of $15. Kennametal also paid $165 million in dividends in fiscal 2013-2015. Kennametal has $700 million in debt ($540 million net debt) and $150 million in pension liabilities. Total equity is $1.17 billion, but a large portion of this ($514 million) is goodwill and intangible assets. If Kennametal didn’t make the large acquisition ($607 million) during the peak of its cycle, along with buying back stock and paying a generous dividend, they’d have a debt free balance sheet and excess cash right now. A debt free balance sheet would put them in an extremely advantageous position during today’s difficult operating environment. They could either acquire or buyback stock at much more attractive prices. Instead, they’ll need their free cash flow ($100 million 2017E) to continue to pay for past capital allocation decisions.
In conclusion, cyclicals can be great investments, but understand and manage the risks. Don’t extrapolate booms or busts and avoid leveraged balance sheets. And if you’re a cyclical business, don’t give in to the Wall Street locusts. Avoid the swarm and protect your balance sheet. You’ll be in a much better position to not only survive, but act opportunistically during your industry’s next inevitable bust.